How to assess financial strength of a company?

(This is part 5 of the ‘Investment Research Process’ series. You can read the previous parts here: 4, 3b, 3a, 2, and 1.)

How to assess financial strength of a company? Answer: by looking at three key elements:

  1. Solvency
  2. Liquidity
  3. Profitability

Before we go into the details on how to do so, let us take a step back and look at the overall process we have been following so far.

Remember, at this stage in our analysis, we have narrowed down to a list of companies which are:

  • in sectors we understand (i.e, within our Circle of competence)
  • the strongest players in those chosen sectors (Concentrate On the Strongest Candidate- COSC)
  • in a business environment which we understand to be favorable for the foreseeable future (Environment analysis)
  • and are run by ethical and efficient management (Management quality)

All of the above were more or less ‘qualitative’ analysis. We can do the above without investing too much of our time and effort. Simple observations and reflections will take us there.

Remaining stages in our analysis – finding the durability of the competitive advantage and finding a fair valuation range etc will take a much more deep dive effort. And we want to spend our time wisely and limit our analysis to a few rock solid businesses.

So we go through a process of elimination. Financial strength analysis is a great way to do so.

Assessing the financial strength (on its own) may not tell us which company to buy- but it can certainly tell us which company to avoid.

Why is financial fitness crucial?

Tell me where I am going to die, so I will never go there.” – Charlie Munger.

In the long term, only two factors account for most major stock losses.

  1. Earning growth of the company is reduced due to some internal or external factors
  2. The market believes that the company is in danger of running out of cash, and may go bankrupt.

Most analysts you see on Business TV will only focus on point 1. Earning growth trends of companies will be scrutinized every quarter by brokerage houses in detail and most individual investors thus look only at this factor.

While important in itself, a reduced earning growth or even losses for sometime may not make a company go bankrupt if it has sufficient financial strength. The financial strength of a company is not analysed in most (if not all) brokerage reports or business TV discussions.

Which is why we, the individual investors need to really look closely at this:

How likely is any of the following three things happening to the company?

  • Company is unable to pay interest on its debt (solvency issues)
  • Company is unable to pay its short term obligations (liquidity issues)
  • Company doesn’t generate enough operating cashflow to sustain itself, grow or return capital to investors (profitability issues)

Let us look at the key areas in detail.

Solvency

Solvency measures a company’s ability to meet its interest and principal payments on long term debt and similar obligations as they come due.

If the company cannot make payments on time, it will become insolvent and may require re-organisation or liquidation.

First of all we need to check what is the amount of long term debt as a proportion to its equity capital. (the debt to equity ratio of the company)

I will normally only look at companies where the D/E ratio is less than 0.5. Although my preference is to go for debt free companies.

Also check the Interest Coverage Ratio. This ratio is used to determine how easily a company can pay interest on outstanding debt. The interest coverage ratio is calculated by dividing a company’s earnings before interest and taxes (EBIT) of one period by the company’s interest expenses of the same period:

Interest Coverage Ratio = EBIT/Interest paid

The bigger the ratio, the better. I want an interest coverage of 2 or more. When a company’s interest coverage ratio is 1.5 or lower, its ability to meet interest expenses may be questionable. An interest coverage ratio below 1 indicates the company is not generating sufficient revenues to satisfy interest expenses.

So our basic checks on the solvency of the company:

  • Is the Debt/Equity less than 0.5 ? Discard the company if not.
  • Is Interest Coverage greater than 2 ? Discard the company if not.
  • Is Asset growth greater than Total Liabilities growth? Better if it is.

Liquidity

Current Ratio and Quick Ratio are commonly used to evaluate a company’s ability to pay its short-term obligations.

Current ratio = current assets / current liabilities

Current assets also include Inventory, which may not be very easy to covert to cash quickly. So Quick Ratio eliminates Inventory from the above equation.

Quick ratio = (current assets – inventory) / current liabilities

The quick ratio focuses on assets quickly convertible into cash.

The higher the above ratios, the better the company.

So our liquidity check becomes:

  • Is Current Ratio greater than 2 and Quick Ratio greater than 1? Discard the company if not.

Profitability

Profitability measures the company’s ability to generate profit or positive net income for a given level of sales or investment.

We need to look closely at the financial statements of the company and check the below:

  • Is the Operating Cash Flow positive? Discard the company if not.
  • Is Operating Cash Flow greater than Net Profit? (this is a measure of the ‘quality’ of earnings). Discard the company if the OCF is consistently  lower than Net Profit over last 3 or more years.
  • Is Net Profit growth greater than Total Asset growth? It is better if it is. Not a deal breaker if not.
  • Is Operating Cash Flow greater than the sum (Investing Cash Outflow + Financing Cash Outflow)? Discard the company if not.

The last check is also known as ‘Overall cash flow ratio’.

Overall cash flow ratio = cash inflow from operations / (investing cash outflows + financing cash outflows)

If the overall cash flow ratio is greater than 1, the company is generating enough cash internally to cover business needs. If it’s less than 1, the company will have to either sell its assets or go to capital markets to raise funds.

……………..

End of part 5. Do let me know if you would like to see an example of how this check is done in one of the Nifty listed companies.

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